The present invention is related generally to a method and system for selecting a portfolio of assets for achieving optimum correlation of asset return to a selected standard financial index. More particularly, the invention is related to a highly efficient, rapid method and system for choosing an asset portfolio having the optimum correlation of the asset return to a time dependent financial index, such as a financial liability, at each of a number of selectable asset return levels.
Management of portfolios of assets has historically emphasized maximizing the return on assets with the objective of at least outperforming the market. However, in some financial industries the objective, or the figure of merit, is also related to meeting future liabilities rather than just achieving high return on assets. Frequently, an institution will have a future intended use of the assets which requires their availability at some future time. If assets are performing differently than liability requirements, substantial financial hardship can result. For example, insurance companies and corporate pension plans have well defined future financial liabilities which must be met. Consequently, although return on assets is one important objective, meeting future liabilities is also important and can be even more important in many instances. In fact, many pension plan managers are now required to meet the standards set forth in FASB Statement 87 (Financial Accounting Standards Board) on pension fund accounting. Under the FASB Statement a market interest rate return on pension funds is the standard index and is to be based on A-rated ten year corporate bonds. Under this FASB Statement any deficit in corporate pension funds are now reflected on the balance sheet. Any such deficit would therefore have substantial adverse effect on the apparent net worth of the subject corporation. Consequently, this FASB Statement standard strongly encourages maintenance of a surplus for a pension fund. As an example of the importance of matching the liability requirements under the FASB Statement, consider the percentage change possible for pension plan liabilities, as measured by the accumulated benefit obligation (ABO). If, for example, interest rates increase by 1% in one year over the present rates, the present value of the ABO would decline by 10% if the ABO has a duration of 10 years. Likewise, if interest rates were to drop by 1% in one year, the present value of the ABO would increase by 10%. The potential for such dramatic fluctuations in liabilities clearly deserves careful attention by parties obligated to meet future liability streams.
In order to timely meet future financial liabilities and maintain a proper surplus fund for a pension plan, a number of methodologies have arisen including xe2x80x9cimmunizationxe2x80x9d, xe2x80x9ccash matchingxe2x80x9d; and some preliminary efforts have even been directed to utilizing stock funds.
The xe2x80x9cimmunizationxe2x80x9d method of meeting future financial liabilities uses bonds having substantially the same duration as the liability stream. Duration is a measure of volatility expressed in years, which is similar to, but more precise than, average life. The duration is calculated as the weighted average amount of time to the receipt of the payout. There are however significant drawbacks to xe2x80x9cimmunizationxe2x80x9d, with one primary disadvantage being the relatively low excess return on assets generally achieved by the method. Additional limitations are imposed by the two major assumptions made by the strategy: The yield curve (a plot of yield to maturity on bonds versus their time to maturity) will only make parallel shifts. Consequently, regardless of maturity, when market conditions change, all bonds allegedly move exactly the same amount in yield. This clearly is not the case since there have been substantial inconsistencies in the past for the difference in rates for short-term bonds and long-term bonds. Secondly, all cash flows in excess of required annual payments can allegedly be reinvested at the yield to maturity of the portfolio. This presumption is also clearly not true since sharply declining or rising interest rate environments will make it extremely difficult to carry out reinvestment. Furthermore, this strategy does require more ongoing management of the portfolio in order to sell or buy more securities to match the actuarial schedule and maintain a proper asset/liability match.
The xe2x80x9ccash matchingxe2x80x9d method utilizes a bond portfolio having numerous component bonds with various maturity dates and payout rates to precisely match the liability requirements of the pension plan. Such an approach has the same primary disadvantage as the xe2x80x9cimmunizationxe2x80x9d method and further requires additional effort to assemble the portfolio. Frequently, the xe2x80x9ccash matchingxe2x80x9d method demands payment of a premium to achieve the correct mix of bond rates and maturity. Both of the first strategies (xe2x80x9cimmunizationxe2x80x9d and xe2x80x9ccash matchingxe2x80x9d) must invest in fixed income securities to provide the assurance of receiving the necessary cash flows. In fact, they must primarily invest in U.S. treasury obligations since investments in corporate or mortgage securities increase the chance for default or for call risks which can have the effect of changing the projected cash flow.
Pension plan liabilities or other future liabilities, such as are present in the insurance industry, are long term in nature. Therefore, a future liability stream can greatly benefit from the compounding effect of investment in higher returning assets, such as common stocks. However, attempts to characterize stocks in terms of a time duration parameter or otherwise have not been successful. In the last few years many unsuccessful attempts have been made to develop a system whereby a portfolio of equities is linearly optimized relative to a liability stream. There have been attempts to parallel the xe2x80x9ccash matchingxe2x80x9d techniques with the use of stocks, instead of bonds. This approach has involved matching the expected dividend flow of the portfolio to the liability stream. Unfortunately, stock dividend yields are unpredictable, particularly beyond 3 years in the future. Another major effort in equities has been directed to an xe2x80x9cimmunizationxe2x80x9d type treatment. In this effort an attempt was made to calculate the duration of stocks on an individual basis, as well as on a portfolio basis; but these attempts also have been unsuccessful, primarily due to the long term unpredictability of stock dividends.
In a related patent application, incorporated by reference herein and having U.S. Ser. No. 281,560 and filed Dec. 8, 1988, now abandoned an improved method and system were set forth directed to correlating return on assets to a financial objective over time. In performing the analysis to determine the optimum assets of a portfolio to track the financial objective, the machine time and efficiency of the evaluation process can limit the number of assets considered in constructing the portfolio. Such limitations on the number of assets which are considered for inclusion in the optimum portfolio can also limit the performance of the selected portfolio.
It is therefore an object of the invention to provide an improved method and system for determining the optimum portfolio of assets for tracking a financial index.
It is another object of the invention to provide a new method and system of efficiently selecting the optimum portfolio of assets for tracking a financial index.
It is an additional object of the invention to provide an improved method and system of rapidly analyzing a large number of potential assets to select the optimum portfolio of assets to track a financial index.
It is a further object to provide a new method and system of enlarging the number of potential assets under consideration for inclusion in a portfolio of assets, while reducing the time required to select the portfolio of assets which best track the behavior of a financial index.
It is another object of the invention to provide a rapid, more efficient method and system of selecting the weighted values for assets selected from a universe of possible assets for a portfolio designed to track a financial index.
It is an additional object of the invention to provide an improved method and system for reinvesting cash flow from a portfolio starting with that current portfolio of assets.
Further objects and advantages of the present invention, together with the organization and manner of operation thereof, will become apparent from the following description when taken in conjunction with the accompanying drawings described hereinbelow.